Correcting an externality means pricing it in
Definition
Internalising an externality: making the producer or the consumer bear the full social cost or benefit of their choice, so the price they face reflects the effect on third parties.
- The problem set out in 3.8.1 is that a cost or benefit falling on third parties never reaches the price, so the government's job is to put it there.
- Four families of policy do this: taxation and subsidies, regulation and legislation, state provision, and information provision.
- Taxation and subsidies work through the price, while regulation, state provision and information provision work around it, which is why a government usually combines them.
Taxing a harmful good raises its price
- The tool is an indirect tax, defined in 3.5.1, added to the good rather than charged on income.
- Adding it raises the producer's cost of supplying each unit, so supply falls, the price rises and less is bought.
- In principle the tax should equal the external cost, because that is the amount needed to make the buyer face the full social cost.
Case study
- The Soft Drinks Industry Levy charges 20.8p a litre on drinks with 5 to 7.9g of sugar per 100ml and 27.8p a litre at 8g or more, rates that took effect in April 2026 (Source: HMRC).
- The levy was deliberately banded rather than flat, so a producer could escape it entirely by cutting sugar below the lower threshold.
Subsidies make beneficial goods cheaper to buy
Definition
Subsidy: a payment from the government to a producer or a consumer that lowers the cost of supplying or buying a good, so more of it is sold at a lower price.
- A subsidy is used where the externality is positive, because the aim is to raise the quantity rather than cut it.
- It lowers the producer's cost, so supply rises, the price falls and more is bought, which is the mirror of what a tax does.
- It works on supply rather than demand, because the payment cuts the producer's cost and does not make buyers want the good any more than before.
Example
The Boiler Upgrade Scheme pays £7,500 towards a heat pump, rising to £9,000 for homes off the gas grid replacing an oil or LPG boiler (Source: GOV.UK).
Regulation and state provision work without price
Definition
Regulation: a legal rule that sets a limit, a standard or an outright ban on an activity, backed by enforcement rather than by price.
State provision: the government supplying a good or service directly, so that nobody is priced out of consuming it.
- Regulation suits harm too serious to price, since a limit applies to everyone rather than only to those who cannot afford the tax.
- State provision suits goods with large external benefits, because supplying them free or below cost removes the reason they were under-consumed.
- A tradable permit scheme sits between the two, capping total emissions by law and then letting firms buy and sell the right to emit within the cap.
Example
- Smoking in enclosed public places had been banned everywhere in the UK by July 2007(Source: GOV.UK).
- Single-use vapes have been banned from sale since June 2025 (Source: GOV.UK).
- The UK Emissions Trading Scheme caps emissions from power, heavy industry, aviation and domestic shipping and lets firms trade permits, covering about a quarter of UK emissions (Source: GOV.UK).
- State education and NHS healthcare are both provision rather than pricing, which is why consumption of them is far above what a market alone would deliver.
Information provision changes what people choose
Definition
Information provision: government action to give people the facts about a good so that their own choices take the external effect into account.
- Part of the reason a harmful good is over-consumed is that buyers underestimate the harm, and no seller has a reason to tell them.
- Providing the information shifts what people want rather than what they can afford, which is why it can outlast a tax.
- Compulsory health warnings, plain packaging on cigarettes and public health campaigns are all versions of the same tool.
Exam technique
- Say whether the externality is positive or negative before choosing a tool, because a tax and a subsidy are aimed at opposite problems.
- Explain the mechanism rather than naming the policy, so say that the tax raises the price and cuts the quantity rather than that the government taxed it.
- Never call a subsidy a tax, since a subsidy is money paid out to lower a price and a tax is money taken in to raise one.
Self review
- Name the four families of policy a government can use to correct externalities.
- Explain how an indirect tax changes the price and the quantity of a good with a negative externality.
- State the difference between a subsidy and a tax.
- Why is state provision used for goods with large external benefits?
- Give one UK example of regulation and one of information provision.
